Investment, Idiosyncratic Risk, and Ownership

ABSTRACT

High‐powered incentives may induce higher managerial effort, but they also expose managers to idiosyncratic risk. If managers
are risk averse, they might underinvest when firm‐specific uncertainty increases, leading to suboptimal investment decisions
from the perspective of well‐diversified shareholders. We empirically document that, when idiosyncratic risk rises, firm investment
falls, and more so when managers own a larger fraction of the firm. This negative effect of managerial risk aversion on investment
is mitigated if executives are compensated with options rather than with shares or if institutional investors form a large
part of the shareholder base.